Investment Update - May '10

Europe’s Turn to Add to the Excitement


"I think the important thing is you're seeing the United States in a much stronger recovery than people expected even three months ago." ~ Timothy Geithner, Treasury Secretary, May 2010


Summary:
Despite the recent equity market volatility and correction amidst concerns about Greece and the southern European economies, the important foundational elements of the US continue to trend mostly upward and the US climbs steadily out of its recent recession. Corporate profits are steadily improving, inflation remains extremely low, and the US dollar remains the safe haven of choice. New jobs are being added, albeit slowly, and while unemployment remains high, prospects for new hires continues to be good. The current choppiness in the markets is natural after the large run-up since March ’09, and while we will continue to monitor the potential impact of events in Europe carefully, this may turn out to be a good time for investors to re-establish their long term asset allocations. We remain cautiously optimistic, although we would not be surprised to see the markets trend downward in the near term.

 

Dear Investor –

Once again, bad news sells. The financial media’s panicky rants over the Greece-debt-driven market drop has many investors missing the bigger point. It’s almost as if the financial press and market junkies have grown jaded at the steadily improving economic fundamentals over the last many months. “Bor-ing.” What’s really new since February, when things seemed so much rosier? Frankly, little. Sure, the equity markets have gone through some considerable contortions, but the economic realities are pretty much in precise line with the trends we’ve been observing for some time: the economy continues to improve generally despite the naysayers, key troubled sectors are slowly turning around, and the expectations remain that a fairly substantial, if not robust, recovery is taking place. The markets may be expressing some disappointment that overall growth is not as explosive as some may have hoped for, but slow and steady generally wins the race in the long term.

But markets do hate uncertainty, and while some economists and soothsayers have credibly stressed their perceived weaknesses in the economy, perhaps the biggest factor is the death-in-the-family pall that still grips investors in the aftermath of the great recent financial crisis that nearly put the US economy permanently to rest. If nothing else, investors have every right to be skittish and downright jumpy – especially those who even ventured back into the waters. After having experienced the impacts of the first great contagion – the punch bowl spiked with poisoned subprime mortgages in 2008 and 2009 – any insinuation of contagion is just plain spooky. The interconnectedness of governments and banking institutions not just in Europe, but globally, is only adding to the anxiety.

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What’s Up With Europe?

It’s in the headlines, and it’s clobbering the markets, so let’s take a minute to discuss. For years, Greece, a member of the European Union and whose currency is denominated in Euros, has been living way beyond its means. Compared to the developed northern countries in Europe – i.e. Germany, and France – no one can venture to label Greece “fiscally conservative”. In fact, Greek debt has run up, thanks to regular cooking of the books, a relatively unproductive workforce, and corruption to such a large percentage of GDP – over 115% -- that it has been dropped to junk status, and heading to default. Although Greece represents a mere 2% of the Eurozone economy, the failure of its economy would have massive impacts on entities there holding its debt (particularly the large banks in Europe), as well as on the Euro currency itself. Moreover, other countries in Europe -- notably Italy, Spain, Portugal, and Ireland -- are not all that far behind in terms of fiscal prudence. A domino effect could take place, which would have dramatic impacts on the banking system and the whole gamut of national economies. As it was, the Euro, for so long the currency of reason, has been brutally bashed, dropping to its lowest levels since 2005.

So, much like the “Asian Contagion” of the late ‘90s, and the recent sub-prime debacle, massive uncertainty has been introduced to the markets. Unlike the US, however, Europe lacks the political system to fix problems that lie between countries. There may be a European Central Bank, but it doesn’t have the authority to insist that Greece or any other nation, for that matter, get its budgetary act together. As a result, the debt issue has grown from pimple to tumor. Fortunately, and at the eleventh hour, a package of aid amounting to about $145 billion was assembled from the Eurozone countries and the IMF (into which the US will contribute about $7 billion, by the way), and a total of about $1 trillion is being caballed together to assist the other struggling European nations as well. This package buys these nations some time, but doesn’t guarantee they’ll get their individual budgets in order. Moreover, this aid comes with steel strings attached, and Greece will have to make tremendous budget cuts, which will further damage its already deteriorating economy, perhaps driving it into depression from recession. Don’t be surprised to see an escalation of labor strikes in Greece, and elsewhere, as a result.

Now, as a savvy reader, you may be asking, “why does this affect the US markets?” A number of important reasons. First, the huge European budget cuts in Greece and other debt-ridden nations will further slow economies currently in, or near recession, further impacting global growth, reducing imports of US goods. Secondly, the concerns about the institutions having to raise interest rates to cover these costs increasing the amount and cost of borrowing there, forcing interest rates to rise here over time. Third, the impacts of a stronger dollar currency against the Euro could swing in either direction – it could hurt exports as American goods suddenly become more expensive to Europeans, or it could cheapen imports of European products here. Finally, in this highly interconnected world, many of the largest investment banks in the US – including Citigroup, Goldman Sachs, JP Morgan – have considerable holdings based in Europe, and defaults on this debt could significantly impact these larger banks. Net result – added uncertainty (and the markets love to panic over uncertainty), despite the fact that our exports to Europe represent a mere 1.5% of US GDP.

Overreaction? All said, probably. Unlike the sub-prime crisis, when no one knew who held what, or even what constituted a toxic asset, there’s much more transparency regarding the various debts owed, and which institutions are holding troubled assets. Moreover, there’s a good chance that current stock prices have factored in these issues – even the possible collapse of the Eurozone -- which may alleviate much further downward pressure on stock prices. Furthermore, funds previously allocated to the now-less-than-desirable European equity and bond markets may be redirected to the more promising and stable US markets, raising stock prices and lowering bond yields (raising bond values) here.

 

But it’s not just Europe. Other factors are also playing on the downside of the markets. China, for one, is actually looking to slow their hyperactive growth curve, cutting back on purchases and development. They’ve threatened this before, and not delivered. Closer to home, Goldman Sachs, Wall Street’s most perfect child, has not only been found smoking in the boys room by the SEC playing both sides of the subprime crisis, but it turns out they’ve been smoking with several of the other top financial firms on Wall Street as well. Who’d ever think Wall Street could behave so despicably?

And then there’s this massive, multi-thousand page piece of Financial Regulatory Reform legislation that’s finally passed the Senate, and hardly fully understood. The package now has to be reconciled with the package passed months ago in the House, and most likely will be watered down a tad before it gets to the President. The impacts of these reforms will take years to appreciate, but clearly they are directed to preventing the kind of massive breakdown that both led to the recent financial crisis and extended it. It’s far from perfect, there’s still much to add, but it represents a very important first step. We pray it won’t stop there. Nowhere, for example, does it begin to address the issues of SIPC protection for investors, which many assert after the recent massive theft fraud blowups – i.e. Stanford and Madoff -- is proving to be an oxymoron. But that added element of uncertainty will be, at least for now, taken off the table.

Perhaps a key takeaway is that the incredible political paralysis in DC has given way to the passage of two historic pieces of legislation: health care and financial reform. Who’d have thunk?

Slower growth equals good growth. After a recession, economic growth (as measured by GDP) typically ramps up in strong fashion. Indeed, the 9% growth rate seen during the last quarter of 2009 suggested this possibility, with the anticipated “V-shape” pattern a joy to both market and economist bulls. The reality is something far more realistic, however, and domestic economic growth seems to be settling in to a range closer to 3% or so. Though this level of growth can disappoint (witness the markets unhappiness last week with the infinitesimally negative index of leading indicators), the upside of this slower growth pattern could be very positive to long term health: because inflation is seen less of a threat, and the focus remains shifted toward continued economic growth, it allows for a relaxed monetary policy by the Federal Reserve. The tension between the fears of recession and inflation is the ongoing yin-yang war those guiding the economic ship are trying to keep from flipping over. Each side is comprised of the fanatics that make up the investment community, and respond violently, it seems these days, with any listing to one side or the other. Tranquilizers, anyone? (Or, perhaps Dramamine?)

So, who really pushed the button? Meanwhile, just a few short weeks ago, the US markets took an all-time-greatest-one-day plummet, dropping over 9%, in what turned out to be a pretty brutal week. The SEC, the blind men and the camel are all trying to figure out what happened. Some trader accidentally hit the “billion” button instead of the “million”, was the thought. Others are blaming it on the hyper-speed, computer generated intermarket trading (called “flash” or “high frequency trading”) that many are seeking to regulate. All agree it wasn’t supposed to happen, and represents a clear and present market danger. For years there have been calls for controls of these sorts of things – including the lack of regulation and integration between derivatives markets and other markets -- but once again, it always seems to take a crisis to effect change. As I repeatedly suggest to my teenage son, pain is a tough way to have to learn, but sometimes it’s the only way. Congressional calls for regulation may lead, finally, to some fruition. In any case, we’re still left with a hard reality, that technologically the SEC is at least ten years behind the times, as emphasized by former SEC Commissioner Arthur Levitt. He should know. Hardly reassuring, indeed.

 

On the Bright Side

We’re now at a point where an individual can pick any key economic indicator and support the argument for improving health. Retail sales, new homes sales, durable goods, exports, shrinking inventories, productivity…. You name it, and pretty much every key indicator has been moving in the right direction for the last six months. Inflation – the cry of many just a few short months ago – was then, and remains now, non-existent. Ironically, with unemployment so high, wage pressure will remain low, helping keep inflation low for some time. And oil continues to trade in a range roughly half its price just a couple of years ago. Businesses and banks are finally well capitalized. Moreover, anticipated profitability among major US corporations continues to grow – earnings are expanding, and are projected to appreciate fairly strongly through 2011. This portends good things for stock prices, and with the S&P now trading at just over 13 times earnings, makes stock prices historically cheap to moderate. Keep in mind that, at the end of the day, stock prices are about expected earnings, and once the emotions and market psychology give way to reason (which they always, ultimately, do), prices should rebound. Perhaps European and some Asian markets look less attractive at the moment, but even go outside the US, and emerging market economies are showing substantial strength as well.

Problems? Sure. The headwinds haven’t changed. Much of what we saw back in March remain valid concerns, when we clearly perceived European debt, currency swings between the dollar, British pound and Euro , and China’s planned slowdown as headline issues. We also were worried about the potential impacts of municipal and local cutbacks, continuing credit constriction for commercial real estate and small business, and geopolitical and US political turmoil. Of course, once we hit the political silly season, particularly if the economy clearly has taken positive flight, the drums will be beating for Congressional heads over the “outrageous” budget deficits. In any case, the handoff from the stimulus package is now mostly over – it’s now up to the economy to fly on its own.

Last, but not least, is the concern about employment. With the unemployment rate hovering near 10%, and the underemployment rate nearly twice that, the impact on the quality of life of Americans is extraordinary. Equally unfortunate, has been the lack of a significant uptick in household income per hours worked for many years. It’s not popular thinking, but the stimulus package could have (and should have) gone much further in terms of boosting small business hiring and other important areas that could have truly softened the employment pain. As a result, it may take some time for unemployment to come down to normal levels, more time than it has in past recessions. Keep in mind that this was no ordinary recession.

Yet the employment seems to be improving on the whole. As expected, payroll numbers have swung to the positive side of the ledger, after trending up as far back as January of ’09, at which point we stopped losing more jobs than the prior months. We are now adding jobs, 229,000 as of April. With businesses still holding near-record levels of cash, and back to being profitable, we expect these numbers to continue to trend upward. Yes, unemployment will remain high for some time – as many are coming off unemployment benefits and more are added to the workforce, and recent unemployment claim numbers have inched up ever so slightly. But this tends to be among the most historically lagging area in the economy to improve after a recession, but improve it will.

 

Outlook: Still Pretty Darn Good

With all the tumult, which may continue for the short term, we still are left with a generally positive outlook, particularly for the mid and long term. Even after the recent correction these last weeks, the markets have recovered nearly 70% of their losses since their highs in October 2007. The recent correction seems very much in keeping with the normal drops experienced in most improving markets, and we expect this sort of trend to continue. Moreover, equity markets remain reasonably priced, perhaps even cheap. Even though GDP growth may not be sizzling, a slow, sustainable growth pattern is probably better for the long term health of both the economy and markets than something more frenetic. The upshot is that economy is strengthening and, over time -- and barring some extraordinary and unseen forces -- the markets should continue to do so as well.

For investors -- what now? Asset allocations should be largely returning to normal levels. As we have seen over the last few market drops, asset allocation has been effective in limiting portfolio volatility. Investors should brace for continued short term volatility in the equity markets, however. New investors should consider dollar-cost averaging as they enter. We see a growing benefit in some of the more domestic, large cap and dividend paying sectors, and our concerns about possible pressures on bonds has softened in the short term as particularly high quality and Treasury issues have become safe havens. We will need to be wary over the longer term, however, as Treasuries may be moving into bubble territory. Short term yields and money markets continue to remain extremely low with federal funds remaining at near zero interest rates, making many immediate and fixed annuities less attractive. Municipal bonds should be chosen with caution given the highly stressed budgets of municipalities. Equity investors who are able to withstand volatility might be looking for opportunities in these downturns for the long-term.

Continuing to offset both equity and bond risk due to instability in Europe remains the flight to the safety of the US. Fixed income investors who can withstand some market volatility should begin to consider dividends from large cap stocks as both a hedge against a growing stock market, as well as an opportunity to pick up some good dividend yields. Highly conservative investors focused on capital preservation, however, may choose to retain short-term and cash positions during this volatile period, and hold off taking new positions in long term bonds or dividend stocks.

Once again, investors should consider their tolerance for risk, consider their needs for income, and invest carefully.

To all, keep the faith, relish life, and enjoy the warm weather. Of course, please feel free to call with any questions or thoughts.


Peace,
Ron Stein

Good Harvest Financial Group
631.423.6501
rstein@goodharv.com

 

Disclaimer: each investor has different needs. The information herein should not be used to direct investment decisions without assistance. No guarantees can be made or implied in the above information.